Carry trades are bets on unhedged interest rate parity
A currency carry trade consists in borrowing in a currency with a low interest rate and investing the funds in a currency with a high interest rate. Without hedging, the investor is betting that the rate differential will not be offset over time by changes in the exchange rate between the two currencies: in theory, currencies offering higher interest rates will depreciate over time against those offering lower rates, and by a similar proportion to the interest rate differential, in line with the unhedged (FX) interest rate parity theory.
Although the theory holds true over the long term due to arbitrage opportunities, it rarely holds true over the short term, and many investors use carry trade strategies to exploit these market inefficiencies. The strategies can be highly profitable, with returns sometimes exceeding average equity market returns. However, they also carry significant risk.
In 2024, one popular carry trade strategy was to borrow in Japanese yen (short the currency) and invest the proceeds in Mexican pesos to take advantage of the 10-percentage-point differential between Mexican and Japanese 3-month yields (see Chart 1). However, the trade delivered contrasting performances over 2024. Until the end of May, it outperformed the US equity market. But at the start of June 2024, the results of the Mexican presidential election triggered a sharp drop in the peso, which then accelerated the following month when the Japanese central bank unexpectedly hiked interest rates. As a result, in the summer of 2024, the foreign exchange (FX) component turned the strategy into a loss-maker. FX volatility therefore had a major impact on the profitability of peso/yen carry positions. However, from mid-2025 onwards, the peso recovered against the yen, leading to a widening of the interest rate differential and making the strategy profitable again (Chart 1).
While interest rate differentials evolve slowly and fairly predictably, depending notably on monetary policies, exchange rates are often volatile and unpredictable. Hence, the potential return on a carry trade is not solely dependent on the interest rate differential; FX risk can completely modify the trade’s performance, wiping out or amplifying the expected gains.
FX volatility has a decisive impact on the performance of these strategies
The expected return on carry trade strategies needs to be weighed against the volatility of the currency pair by calculating the normalised gain per unit of risk. Comparing carry-vol ratios – which measure the interest rate differential relative to FX volatility – makes it possible to identify more suitable investment strategies than using interest rate differentials alone. When FX volatility risk is taken into account, the most attractive carry trade strategies are not limited solely to investments in emerging currencies (which are often more volatile). They can also be found in G10 currency pairs: it can be worthwhile to bet on a narrower interest rate differential offering lower FX volatility (and hence a higher carry-vol ratio). For example, the so-called G10 strategy consists in selling or borrowing (shorting) three lower yield G10 currencies and selling or investing (going long) in three higher-yield G10 currencies.
Since January 2024, based on carry-vol ratios, it has been more attractive to borrow in Swiss francs (CHF) and invest in US dollars (USD) than to borrow in USD and invest in the Mexican peso (MXN), even though the USD/MXN pair has a wider interest rate differential (Chart 2).
Chart 2: Breakdown of the return on two carry trade strategies since 2024
